Inflation Expectations and the Stock Market

A blog about business and economics.
Dec. 18 2012 10:38 AM

Inflation Expectations and the Stock Market

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There are no ironclad proofs in macroeconomics, but this chart above is, I think, the best evidence for the proposition that the economy continues to suffer a substantial shortfall in demand. The red line is the change in the interest rate premium for a regular 10-year treasury bond over an inflation protected 10-year treasury bond. In other words, it's the change in financial markets' expectation of inflation over a 10-year horizon. The blue line is the change in the value of the S&P 500. The point of the chart is that the two series are correlated—higher inflation expectations boosts share prices.

Now the point is not that faster inflation is good for growth or good for equity prices as a general matter. In fact it isn't. And the fact that it isn't is what makes the chart telling. In "ordinary" times, we'd expect higher inflation expectations to reflect adverse supply shocks or irresponsible central banking and if anything depress share prices.

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But that's not what we see. Instead we seem to see an economy where higher demand leads to both more real output and higher prices. And that's exactly what you'd expect from an economy suffering from a demand shortfall. Higher demand would lead to more real output—millions of currently unemployed people would get jobs, plenty of currently vacant office space and store fronts would be leased, and factories would run at higher capacity. But higher demand would also lead to higher prices—millions of new workers would mean more driving and higher gas prices, popular restaurants would raise prices, rents in supply-constrained areas would accelerate, etc.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.

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